The phrase neutrality of money refers to an economic theory that changes in the supply of money do not primarily impact the actual variables of an economy, such as the rate of employment or the gross domestic production (GDP). As a concept, neutrality of money has been a tenet of classical economics since the 1920s. When money is introduced into an economic system, prices and wages rise proportionately, but the overall supply and demand for goods and services remains unchanged, theoretically. Although neutrality of money holds true over long periods of time within an economic system, the disequilibrium produced in an economy by rapid increases or decreases in the money supply does lead to short-term changes in employment, production, and consumption. New Keynesian economic models discard the neutrality of money, pointing out the significant impact on real economic variables that credit and debt can have.

Long-term economic cycles reflect neutrality of money, but in the short-term, infusions or subtractions of money produce changes in the employment level, production of goods, and consumer behavior. For example, an oversupply of money may increase demand for goods and services and encourage more spending. Since demand outstrips supply, prices increase. Companies may then increase production and hire more employees to meet demand. Finally, the system arrives at a new equilibrium, where supply and demand balance each other.

The quantity theory of money states that there is a proportional relationship between prices and the money supply. According to the Fisher equation, the quantity theory of money (QTM) states that as the money supply and the velocity of money increase, prices and transactional volumes also increase. Based on this theory, monetarists advocate that the money supply be controlled within a narrow range to balance the conflicting goals of stimulating the economy and controlling inflation. Most monetarists favor a gradual reduction in the money supply over time to achieve an initial bump in productivity followed by the deflationary effects of monetary contraction.

Although short-term influences of money supply changes do cause changes in real economic variables, price and wage stickiness can undermine these effects. For example, even when the United States Federal Reserve prints more money, prices and wages may not increase due to a variety of factors. Contractions of the money supply are not always accompanied by decreases in wages and prices. Wage and price stickiness complicate the decision-making process of the Federal Reserve with respect to any interventions that it might make in order to stimulate the economy.

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bear78Post 3

I'm not an economist but this makes sense to me. If new money enters a market, what's easier-- to change production or to change prices? Of course, it's easier to change prices, changing production has a high cost.

This is why eventually things end up going back to normal and the money that entered the economy is basically ineffective. If production stays the same and new prices adjust demand and supply, nothing is going to happen. So I think that money is neutral if production remains the same.

fBoylePost 2

@MikeMason-- The way that I understand it, the theory of monetary neutrality says that there will be changes in the economy in the short term but not in the long term.

stoneMasonPost 1

I was part of an economic simulation at school recently which supported this theory.

In the simulation, developed countries and international organizations were investing money in a developing economy to improve conditions. The goal was to reduce problems like lack of basic services-- education and health care-- and improve the economy, thereby reducing poverty and unemployment.

But the key was that despite large amounts of money that was entering the economy, change was taking place very slowly. It took regular financial investment over "years" for poverty and unemployment to go down. So the neutrality of money is true, at least in a short period of time.

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